Up to the 1970s it was mostly observed that inflation does not have a significant effect on growth, or that the effect was even slightly positive (Sarel 1996). However, due to the following decades of high and persistent inflation in many countries1, the available data showed changes in the inflation-growth nexus. It was univocally confirmed that inflation has a negative impact on growth, and macroeconomic policies are aiming to spur growth by keeping inflation at low levels. This having said, intuitively the question arises, how low should the target inflation be? Or, which is the threshold level of inflation between a positive and negative impact on growth? Many authors in the 1990s attempted to solve this question, with fairly divers results. Sarel (1996) analysed a panel of 87 countries over the period 1970 to 1990 using OLS estimation. He finds a structural break at an average annual rate of inflation of 8%. Below this level, inflation has no significant effect on growth, but for inflation levels above 8%, growth is significantly and strongly negatively affected. Gosh and Phillips (1998) find a much lower threshold at 2.5%, and Christoffersen and Doyle (1998), applying Sarel’s methodology on transient countries between 1990-1996, obtain a threshold of 13%. Bruno and Easterly’s (1998) results are somewhat striking. Their analysis is based on a sample of 31 countries that experienced high-inflation episodes over the period 1961-1994, and results in the fact that inflation does not have a significant effect on growth for normal levels, however the relationship becomes negative with high-frequency data and high- inflation observations of 40% or higher.
Motivated by this variety of results, Khan and Senhadji re-examined this issue in their 2001 paper “Threshold Effects in the Relationship Between Inflation and Growth”. They contribute to existing work by extending and modifying their analysis compared to previous literature by, first, looking separately on developing and industrialized countries, and second, by applying new econometric methods, which include the non-linear least squares (NLLS) estimation combined with a hybrid function of inflation, where the threshold level is found with conditional least squares. Furthermore, Khan and Senhadji (2001) use the bootstrap method, proposed by Hansen (1999), in order to test for statistical significance of the threshold effect. Accordingly, their results differ in so far from previous work as the threshold levels for industrialized countries are substantially lower than for developing (1-3% and 11- 12%, respectively). Furthermore, this result is robust to data frequency, perturbations, and even to exclusion of high-inflation observations, which considerably undermines Bruno and Easterly’s (1998) findings.
In the following review I will demonstrate Khan and Senhadji’s (2001) arguments of using the aforementioned techniques and their advantages, compared to traditional OLS estimation, to find reasonable threshold levels. Furthermore, it is shown that the estimated threshold levels are not only statistically significant but also precisely estimated. Moreover, a critical discussion reveals also the weaknesses of the model and provides some extensions from the following literature.
Model and Discussion
First major point Khan and Senhadji (2001) make is that growth rates should be regressed on the logarithm, instead of the level, of inflation. As already shown in Sarel (1996), using the levels of inflation highly skews the distribution across the sample and time as such a regression puts a lot of weight on high-inflation observation, although the majority of countries has medium or low rates of inflation. Moreover, the implication of log models is that multiplicative inflation shocks will have the same effects on growth in economies with high and low inflation, or in other words, if inflation is doubled in both countries, then growth will be affected in the same magnitude. However, the problem of log transformation of inflation rates arises when the rate is less than 1 or even negative, then taking logs is not possible. Unlike Sarel (1996), and later also Burdekin et al. (2004), who convert negative inflation rates into small positive in order to allow log transformation, Khan and Senhadji (2001) adopt the hybrid inflation function of the form:
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The first term is a linear function for values of inflation rates less or equal to one, so that for inflation rates . The second term expresses log of inflation for values above one, such that for inflation rates . By subtracting 1 from the first term, is kept continuous at unity in order to keep it at the turning point from being linear to log linear in .
1 Sarel (1996): The 1970s and 1980s were characterised by severe and persistent inflation.
- Quote paper
- Anna Miller (Author), 2013, Threshold Effects in the Relationship Between Inflation and Growth, Munich, GRIN Verlag, https://www.grin.com/document/263451